Getting In and Out of Revocable Trusts

The University of Texas School of Law Presented: 10th Annual Estate Planning, Guardianship and Elder Law Conference August 14-15, 2008 Galveston Texas Getting In and Out of Revocable Trusts Bernard E. ("Barney") Jones Author contact information: Bernard E. ("Barney") Jones Attorney at Law 3555 Timmons Lane, Suite 1020 Houston, Texas 77027 voice 713.621.3330 fax 832.201.9219 Barney@FlexDraft.com Continuing Legal Education 512-475-6700 www.utcle.org

Revocable Trusts i Table of Contents I. INTRODUCTION.... 1 A. Overview.... 1 B. Scope of this Outline.... 1 C. Appendices.... 1 II. MEANING OF "REVOCABLE TRUST."... 2 A. Characteristics of the Revocable Trust During the Grantor's Life.... 2 1. CREATION OF REVOCABLE TRUSTS... 2 a. Declaration of Trust... 2 b. Agreement of Trust.... 2 c. Joint Grantor Trust.... 2 d. Withdrawal Right Vesting.... 2 2. RIGHT TO REVOKE.... 3 a. Generally.... 3 b. "Irrevocable Revocable" Trusts... 3 3. BENEFICIARIES.... 3 4. TRUSTEE.... 3 5. MERGER... 4 B. Post Death Characteristics of the Revocable Trust.... 4 1. THE WILL SUBSTITUTE REVOCABLE TRUST.......................... 4 2. "POUR-BACK" MANAGEMENT TRUST.... 4 III. TAX CONSEQUENCES OF REVOCABLE TRUSTS DURING THE LIFETIME OF THE GRANTOR.... 4 A. Income Taxation During the Grantor's Life.... 4 1. GENERAL RULE.... 4 2. EXCEPTIONS TO THE GENERAL RULE... 5 a. Taxpayer I.D. and Filing Requirements.............................. 5 (1) Return Requirements for Taxable Years Beginning Prior to January 1, 1996... 5 (2) Return Requirements for Taxable Years Beginning on or After January 1, 1996... 5 (3) Taxpayer I.D. Requirements Follow Filing Requirements........... 7 b. Distributions from Qualified Subchapter S Trusts...................... 7 c. Passive Activity Losses... 7 d. Section 1244 Stock.... 7 e. Percentage Depletion... 8 B. Transfer Taxation During the Grantor's Life.... 8 1. GENERAL RULE.... 8 2. GIFT TAX RETURN REQUIREMENT FOR TRANSFERS TO REVOCABLE TRUSTS.... 8 3. GIFTS WITHIN 3 YEARS OF DEATH.... 8 a. Background.... 8 b. New Rule for Certain Qualifying Revocable Trusts--IRC 2035(e)........ 8 (1) General Rule.... 8 (2) The Incapacitated Grantor... 8 (3) Partial Retroactive Effect.... 9 c. Rule Applicable to Non-Qualifying Revocable Trusts................... 9 (1) General Rule.... 9 (2) Impact of the Rule... 9 (3) Exception--Management Trusts with "Pour-Back" Clause.......... 10 (4) Exception--Competent Grantor as Sole Permissible Beneficiary..... 10 (5) Planning Options... 13 C. The Incapacitated Grantor.... 14

ii Revocable Trusts D. Marital Gifts to a Revocable Trust.... 15 IV. POST DEATH TAX CONSEQUENCES OF REVOCABLE TRUSTS.... 16 A. Special Income Tax Election Available to "Qualified Revocable Trusts."... 16 1. "QUALIFIED REVOCABLE TRUST" DEFINED......................... 16 2. LIMITATIONS ON THE POWER TO REVOKE........................... 16 3. THE INCAPACITATED GRANTOR.... 16 4. TIME, MANNER AND DURATION OF THE ELECTION.................. 17 5. EFFECTIVE DATE.... 17 B. Income Taxation of "Non-Qualified" Revocable Trusts.... 17 1. ISSUES REGARDING SPECIFIC ASSETS.............................. 17 a. S Corporation Stock.... 17 (1) Estate as Permissible Shareholder............................. 17 (2) Trust as Permissible Shareholder............................. 18 b. Passive Activities.... 18 (1) $25,000 Rental Real Property Deduction Allowance--IRC 469(i)... 18 (2) Deduction for Sale of Entire Interest--IRC 469(g).............. 18 c. Depreciating Assets--IRC 267(b)................................. 19 2. GENERAL POST DEATH INCOME TAX ISSUES........................ 19 a. Requirement to Make Estimated Tax Payments....................... 19 b. Allocation of Estimated Tax Payments to Beneficiaries................. 20 c. Joint Tax Return.... 20 d. Personal Exemptions, Rates.... 20 e. Charitable Set Aside.... 21 f. Fiscal Year.... 21 C. Income Tax Rules Unaffected by Use of [Qualified or Non-Qualified] Revocable Trust.... 21 1. BASIS STEP UP.... 21 2. SEPARATE SHARE RULE.... 21 a. Generally.... 21 b. Application to Estates.... 22 3. 65 DAY RULE... 22 a. Generally.... 22 b. Application to Estates.... 22 D. Revocable Trust Trustee Discharge from Liability.... 22 E. Revocable Trust Trustee Transferee Liability and Limitations.... 22 1. THE PROBLEM.... 23 2. ARGUABLE SOLUTION... 23 V. RULE AGAINST PERPETUITIES.... 23 A. Foundation of the Rule.... 23 B. Application of the Rule to Revocable Trusts.... 24 1. GENERALLY.... 24 2. "IRREVOCABLE" REVOCABLE TRUSTS.............................. 24 a. General Rule.... 24 b. Revocability Only with Consent of Another.......................... 24 c. Temporary Irrevocability Due to Grantor's Incapacity.................. 24 d. Retained Power of Appointment.... 25 3. SUBSEQUENT ADDITIONS... 26 4. COMMUNITY PROPERTY CONSIDERATIONS......................... 26 5. CONSEQUENCES OF VIOLATING THE RULE.......................... 27 VI. COMMUNITY PROPERTY IN REVOCABLE TRUSTS.... 27 A. Other Outlines Addressing this Topic.... 27 B. Community Property - Non Pro Rata Issues.... 27 1. TYPICAL SCENARIO.... 27 2. ITEM THEORY vs. AGGREGATE THEORY OF COMMUNITY PROPERTY.... 27

Revocable Trusts iii 3. NON PRO RATA DISTRIBUTIONS: POSSIBLE SALE OR EXCHANGE TREATMENT.... 28 4. SPOUSE AS INDIVIDUAL OWNER VS. SPOUSE AS FIDUCIARY.......... 28 a. Issues.... 28 b. Possible Advantage of Joint Revocable Trust Plan..................... 28 5. EXCHANGE OF IRD.... 28 VII. FUNDING REVOCABLE TRUSTS.... 29 A. "Bad" Assets for Revocable Trusts.... 29 1. ASSETS WITH BAD TAX CONSEQUENCES............................ 29 2. ASSETS SUBJECT TO DUE-ON-SALE OR OTHER RESTRICTIONS........ 29 a. Operation of Typical Due-on-Sale Clause............................ 29 b. Federal Preemption of Certain Due-on-Sale Clauses................... 29 3. HOMESTEAD... 30 a. Due-On-Sale Considerations... 30 b. Creditor Concerns.... 30 c. Ad Valorem Tax Concerns.... 30 (1) Legislative Rule; Specific Exemption for Homestead Owned by a "Qualifying Trust."... 31 (2) Planning Considerations for Revocable Trusts................... 31 4. P.C. AND P.A. STOCK.... 31 B. Lifetime Funding Levels.... 32 1. FULLY FUNDED.... 32 2. "UNFUNDED."... 32 a. Technical Requirement That Every Trust Have Property................ 32 b. Statutory Exceptions.... 33 c. Pour-Over Funding.... 33 3. STANDBY FUNDING.... 33 4. PARTIALLY FUNDED... 34 C. Lifetime Funding Techniques.... 34 1. TRADITIONAL--RE-TITLE IN THE NAME OF THE TRUSTEE............ 34 2. DRY TRUSTS/UNDISCLOSED TRUSTS... 34 3. BLIND TRUSTS/NOMINEE ARRANGEMENTS......................... 35 D. Funding with a Pour-Over Will.... 35 E. "Magic Wand" Funding.... 35 1. THE TECHNIQUE.... 35 2. THEORETICAL EFFICACY.... 35 3. PRACTICAL FAILINGS.... 36 a. Sledge Hammer Funding... 36 b. Illusory Full Funding... 36 c. Clouding Title with Ambiguity.... 36 d. Post Death Discretionary "Pour-Back" Funding....................... 37 VIII. USES AND MISUSES OF THE REVOCABLE TRUST.... 37 A. Planning for Incapacity.... 37 B. Avoiding the Cost and Hassle of Probate.... 38 1. PROBATE COURT PROCEEDINGS... 38 2. CLEARING TITLE INTO THE ESTATE... 38 3. CLEARING TITLE INTO THE BENEFICIARIES......................... 38 4. POST DEATH ADMINISTRATION.... 39 C. Avoiding the Delay of Probate.... 39 D. Maintaining Privacy.... 39 IX. MARKETING REVOCABLE TRUSTS.... 39 A. Editorial.... 39 B. New Ethical Guidelines.... 40

iv Revocable Trusts APPENDIX ONE: POUR OVER WILL... 42 APPENDIX TWO: SOLE SETTLOR REVOCABLE TRUST... 52 APPENDIX THREE: JOINT SETTLOR REVOCABLE TRUST... 70 APPENDIX FOUR: FLEXDRAFT - ESTATE PLANNING DOCUMENT ASSEMBLY SYSTEM... 93

Getting In and Out of Revocable Trusts Bernard E. Jones I. INTRODUCTION. A. Overview. Revocable trusts present many issues and the debate over their appropriateness as an estate planning tool has been going on for years. See, e.g., Richard W. Desmond, Revocable Trust After Death of Grantor, TRUSTS AND ESTATES, April, 1977; Stanton D. Rosenbaum, Unique Applications and Pitfalls of Revocable Trusts, 29 S. CAL. TAX INST. 503 (1977). Some of the participants in this debate have confused the matter by fostering (although not always expressly advocating) the popular misconception that a fully funded revocable trust is an appropriate Will substitute, carrying with it untold advantages in money, time and complications saved. See, e.g., Norman F. Dacey, How to Avoid Probate! (Crown, 1983); and more recently, Robert A. Esperti and Renno L. Peterson, Loving Trust: The Right Way To Provide For Yourself and Guarantee the Future of Your Loved Ones (Viking, 1988). As a result, estate planning professionals may often find themselves reluctantly picking sides between two apparent camps: those that like and always use revocable trusts, and those that dislike and prefer to never use revocable trusts. This misdirected disunity in the ranks is an unfortunate state of affairs. The simple question "are revocable trusts good or bad" is simply the wrong question. When utilized for the right reasons and funded at the right time with the right assets, revocable trusts are an excellent estate planning tool. On the other hand, when hurled like some all purpose placebo at every estate plan that comes through the door, it is only by fortunate coincidence that revocable trusts produce the desired advantages. And the improvident use of a revocable trust can result in very unfavorable tax consequences. B. Scope of this Outline. The fruitful inquiry, then, is directed not at any inherent virtue or danger of the revocable trust itself, but at whether the funding of a revocable trust with any of the client's property will, on balance, be beneficial to the client. The answer will always turn on two specific circumstances, both of which must be evaluated on a case by case basis: (1) the client's property available for funding into the trust, and the tax (and other) ramifications of the various funding alternatives; and (2) the extent to which a revocable trust is the best means available to realize the particular client's needs and wishes. The outline begins with a discussion of the basic legal principals of revocable trusts. Then, keeping this twofold vantage point in mind, the outline covers several topics, including: (i) the federal income, gift and estate tax consequences of revocable trusts both during the grantor's life and after his or her death; (ii) the application of the rule against perpetuities to revocable trusts; and (iii) funding issues, including specific "bad" assets that generally should not be placed into a revocable trust prior to the grantor's death, the appropriate extent of lifetime funding, and several of the techniques available for lifetime funding. The outline concludes with selected forms. C. Appendices. The first three Appendices are forms. They are for illustrative purposes only. They were produced using the FlexDraft estate planning document assembly software developed by the author and used by Davis, Ridout, Jones & Gerstner, L.L.P. The practitioner should make his or her own independent evaluation and determination whether and to what extent they may be appropriate in any given situation and whether and to what extent they should be revised for use in a given situation. The author and the publisher are not responsible for the tax or other consequences of using these forms in any particular situation. Use them at your own risk.

2 Revocable Trusts The fourth Appendix is a brochure for the FlexDraft system. II. MEANING OF "REVOCABLE TRUST." A trust is an arrangement for the ownership of property. In particular, a trust effectuates a division of property ownership into its two component parts: (1) legal title, which is vested in one or more trustees, and (2) beneficial interest, which inures to one or more beneficiaries. Thus, a valid trust exists whenever three elements are present: (1) property, (2) held in the name of one or more trustees, (3) for the benefit of one or more beneficiaries. The trustee, as legal owner, generally has the right to manage, administer and dispose of the property. The beneficiary is entitled to all the benefits of the property: its income, appreciation, use, etc. See generally Bogert, Trusts, Hornbook Series, 6th Ed., 1 (1987). A. Characteristics of the Revocable Trust During the Grantor's Life. The typical revocable trust will have the following distinguishing characteristics during the life of the grantor: (i) it is created inter-vivos, that is, during the lifetime of the grantor; (ii) the grantor retains the right to revoke the trust and obtain a return of the trust property; (iii) the grantor is the primary beneficiary for life (the trust is "self settled"); and (iv) the grantor is also a trustee or co-trustee, although a third party trustee is common. However, there are many possible variations as to each characteristic that often do not alter the basic tax and other issues that are present. 1. CREATION OF REVOCABLE TRUSTS. a. Declaration of Trust. Most revocable trusts are created by (i) the execution of an inter-vivos declaration of trust under which the individual grantor establishes a trust, declaring himself to be the trustee, and (ii) the contemporaneous transfer of the initial trust property from the individual as grantor to the individual as trustee. This outline will generally presume the existence of a revocable trust created inter-vivos by a single grantor for himself. However, there are numerous alternative possibilities. b. Agreement of Trust. The most common alternative to a declaration of trust, where the grantor and trustee are one and the same, is an agreement of trust, where the trustee (or at least one co-trustee) is a third party. c. Joint Grantor Trust. Revocable trusts are often created jointly by a husband and a wife as co-grantors, naming one of the spouses as sole trustee or naming both of the spouses as co-trustees. A joint grantor trust can be created by agreement (naming a third party and/or one of the spouses as trustee or co-trustees) or by declaration (naming both spouses as co-trustees). The joint grantor trust is a common technique in Texas and other community property states where the trust property will often consist of community property owned jointly by the husband and wife. (Community property issues are discussed in part VI at page 27 of this outline.) d. Withdrawal Right Vesting. Most revocable trusts are "self settled" by one of the above methods, and this outline focuses on the self settled revocable trust. However, a "revocable" trust can also come into existence upon the vesting of a right of withdrawal held by a trust beneficiary under an inter-vivos or testamentary trust created by another person. If a trust is to terminate upon the beneficiary's reaching a certain age and the trust property is (for whatever reason) not immediately distributed out to the beneficiary, the circumstance is tantamount to a revocable trust in that the beneficiary has the unilateral right to demand the complete distribution of the trust property at any time. For many tax purposes, such a trust will be essentially identical to a revocable trust created by the beneficiary for himself. A "2503(c) trust" that has been extended beyond the beneficiary's 21st birthday is usually an irrevocable trust but it has many of the tax consequences of a typical revocable trust. Under 2503(c) of the Internal Revenue Code (the "IRC") gifts in trust for the benefit of a minor will qualify for the $10,000 "annual exclusion" from taxable gifts under IRC 2503(b) if the minor will receive the trust property upon his